A couple of weeks ago I had the honor of being a guest on my current favorite investment podcast, The Mike Alkin Show. On it we discuss why the contrarian approach can be a profitable one and why so few investors are comfortable with it, how my 12-year poker career has affected my view on investing and we also touch briefly on a few mistakes I have made in my investing career so far. I will dig deeper into this last part in a future post because I think there are some lessons to be learned – especially on what not to do!
Mike has done a ton of deep work on the uranium sector and is probably the person with the most knowledge on the current supply/demand & inventory situation in the space. And I am quite vocal on my findings on individual uranium companies on Twitter, on YouTube and on my blog. So that is how we connected on Twitter.
An example of how I generate investment ideas
As Mike has played a role in my uranium education and since many people have asked me how I generate investment ideas I thought this would be a great segue into how uranium initially caught my interest and perhaps an example of how one can go about turning a fuzzy idea into a possible investment. (Note that this post is only meant to be an example of the initial stages. It won’t cover the work on individual companies as that would be outside the scope of one article.)
How Xi Jinping showed me the light in a roundabout way
In early January I was looking around for new investment ideas and thought Xi Jinping’s speech to the 19th Party Congress could be a starting point. Those are held every five years and they have all been fabulous at predicting what was to come. When Chinese leaders decide on a long-term idea, unlike in a typical western democracy, they follow through. Probably due to a different electoral system (read: dictatorship!).
So who are these speeches aimed at? Probably first and foremost the leaders out in the municipalities throughout China. If they don’t listen to what the President wants and then implements his wishes they will be out of a job. So it gets done.
From GDP growth to blue skies again
What was interesting about this particular speech is that whereas previous five-year plans have focused on GDP growth at all costs! This speech was different in that the environment is mentioned again and again and a recurring theme is how China needs to ”make our skies blue again”. The Health Effects Institute estimates that more than 1.5 million die from air pollution in China.
Deciding on an investment theme
So I started thinking about how an investor can approach this shift. How can China make the transition from dirty coal to cleaner energy sources? Initially I thought liquefied natural gas, LNG, was the play. Recent activity certainly suggested this was a good idea as China had increased their imports from 2016 to 2017 by a whopping 50%!
On top of that, Japan, the largest importer of LNG in the world, had held the course while most analysts had expected Japan to decrease their imports.
But as I started looking deeper into it both of those factors turned out to be warning signs, at least that is how I viewed it. It turned out that China was experiencing bottle necks due to the sudden increase. Their infrastructure couldn’t keep up which might lead to a slowdown, I thought. So that was one risk.
From liquefied natural gas to nuclear power
Another issue came up when I started looking into why analysts expected Japan to decrease their imports and that was related to the Fukushima accident which brought down all of Japan’s 54 nuclear reactors. Most of those were expected to come on soon after but it wasn’t happening at the pace everyone thought it would due to constant court delays. But since it seemed to be a question of time the whole LNG idea started to seem more risky to me and it warmed me up to the idea of nuclear power. And one thing I didn’t initially understand was that LNG wasn’t THAT much cleaner than coal. On an index where coal is at 100, natural gas is at 45. On that same scale nuclear energy is somewhere between 0 and 1! Time for the left to wake up to this fact…
Introduction to uranium in late 2016
A fellow Swedish value investor, Kenny Granath, had alerted me and my investing network to the idea of uranium/nuclear power as an investment theme back in late 2016.
Kenny worked in the nuclear industry so his words obviously carried extra weight due to that fact alone. But not only that, he had shown an ability countless times via his blog to do deep sector analyses in a way I hadn’t seen before from individual investors and those posts were the initial inspiration behind my investment blog in 2014.
But he also said it was probably too early to enter the uranium space as production cuts and consolidation had been minimal at that time and for that reason I simply made a mental note of it but never took a closer look.
CO2 emission quotas explode
I started doing just that in January after having discarded LNG. The climate was increasingly on the agenda and the price chart for CO2 European emission allowances were making some big moves, which had increased the price of electricity in Sweden, and which in turn had renewed my interest for Swedish wind energy companies.
Swedish nuclear power had been on the retreat since 2014 when the owners decided to close down four of their ten remaining nuclear power plants due to the low price of electricity. I had been following the electricity space and the political discussions quite closely since then and my impression was that the owners unsuccessfully had tried asserting pressure on the Swedish politicians to give compensation for delivering baseload energy.
But things have been changing lately and the idea of building new power plants further out in the future has started entering the discussions, so while I knew nuclear was struggling I also knew that it was far from dead in the west. And so after LNG was dropped as an investment idea I started looking closer at uranium.
The uranium price chart from hell
Being a deep value guy a price chart like the above is interesting. The first thing I usually do when a sector peeks my interest is to read the annual reports of the biggest companies in the industry, initially at least those parts give a sector overview. That meant I started with Cameco and what struck me immediately was their mentioning of the fact that the price of uranium was way below the marginal cost of production, as could perhaps be expected by looking at the graph.
Obviously that cannot continue indefinitely so the next step is to look into what has been the cause of it and what may trigger a change to a normal pricing environment where the price returns to equilibrium, ie slightly above the cost of production.
The cause of the bear leading up to 2004
Historically uranium has had these extremely long bear markets that makes your stomach churn. The bear market that proceeded the current one was mainly due to downblending of atom bombs from the former USSR and the US creating the equivalence of a gigantic mine that simply destroyed the market.
The cause of the upwards explosion
Then in about 2004 China started getting interested in nuclear power and due to flooding in some large mines that were supposed to come online this created a squeeze on both the supply and the demand side. The long bear market had made exploration unattractive so when demand started showing up suddenly there was fear there wouldn’t be enough uranium available which along with financial players rushing in created the panic that can be seen in the chart in 2007 and so the price overshot by a large margin.
When financial players started liquidating their holdings, partly due to needing funds in the wake of the financial crisis, the price came back down do equilibrium like levels, which is to say slightly above the cost of production.
The cause of the bear from 2011: Fukushima, Kazakhstan &…???
Then in 2011 the Fukushima accident happened which made Japan decide to close down their reactors for review. At the same time the production from Kazakhstan had increased at a pace no one saw coming from 10% to 30% of global production in only 4 years.
In more normal liquid markets the price would be hurt by such a squeeze but it would also quickly correct after the marginal players had been knocked out. This wasn’t happening and in the first weeks of research I didn’t really get a firm grip as to why even though I had read the reason in Camecos annual report and had seen the graph that explained it. For some reason the significance just didn’t register.
It’s the long-term contracts, stupid!
So I started looking for other views on the sector and for that Real Vision is often top notch. This is a subscription-based financial media service where people who have dedicated large parts of their lives to understanding a particular field are being interviewed in long-form. I have spent countless hours as a fly on the wall during my daily long walks with my dog listening to world-class experts in different areas. And here I found two excellent presentations from Mike Alkin of Sachem Cove and from Adam Rodman of Segra Capital that really hit home the point that was right in front of my nose:
Long-term contracts fixed at high prices during the good years were the reason the miners weren’t dying and killing off supply!
The above graph is the primary reason why uranium is in the state that it is in. And it is also the reason why I pulled the trigger and started investing in uranium now rather than wait.
Once one knows that annual demand is in the 170-180 Mlb range then it becomes only too clear what is going on. And as can be seen below where demand is included in the picture, it is a very constant thing in that business. It doesn’t jump up and down along with the general market cycle.
I would spend a few minutes studying the graph below, which is essentially the same as above but with demand added in. Note that the numbers on the right side, the price, is only applicable for the red line. For all other information, the volume in millions of pounds (Mlbs) is the reference. What the graph tells you is that from 2005-2012 the contracted volume was way above annual demand so the decline in price from 2012 should come as no surprise, especially when factoring in Kazakhstan and Fukushima as well. Those contracts are now rolling off and new ones will have to be signed in the coming years and it will be done at prices that are above the cost of production, which is at least north of $50/lb.